Euro Still Waiting for a Reality Check

By Nicholas Hastings

The euro has spent March bouncing around in a narrow range either side of $1.30.

But with the economic and political background in the euro-zone still deteriorating, there’s little reason to believe it won’t get knocked lower again soon.

The problem, if you can call it that, is bond yields.

After a rise in the immediate aftermath of the Italian elections earlier this month, yields have slipped back again.

This has not only meant lower borrowing costs for most debtors, and successful bond auctions for countries such as Italy, Spain and Ireland, but has led to continued support for the euro.

However, the resilience of the euro can only go so far.

At some point, investors will stop taking their cue from the performance of the bond market, which is being helped by all the cheap money made available to euro-zone banks by the European Central Bank, and start looking at the economic and political reality instead.

The picture there is not pretty.

The political upset in Italy, where the elections left no political party with the power to form a government, appears to have left the country paralyzed.

With negotiations showing no sign of progress, it could face a political vacuum until new elections are held in September at the earliest.
France, meanwhile, looks set to go head to head with Germany over its plans to let its fiscal target slip. President Francois Hollande has warned the country’s deficit will total as much as 3.7% of GDP this year, considerably more than the 3% that the European Union has demanded of member states.

Germany has already said this is a “bad signal” for the rest of the euro zone as it suggests that France is failing to adopt the key structural reforms needed for recovery.

For the euro, however, it is the steady economic deterioration in most parts of the euro zone that is likely to eventually force a reality check.

Apart from Germany, which continues to show an economic recovery that is strongly linked to exports to Asia, other euro-zone members are still struggling.

There is good reason why France, for example, is missing its target.

Recent numbers from the region’s second-largest economy show that unemployment continues to rise faster than expected and the current-account gap continues to widen sharply.

An even more startling sign of the economic ills of the euro zone came with new industrial production data showing a 0.4% contraction across the region in January.

For the moment, disappointment over the lack of recovery in the first quarter of this year hasn’t affected the ECB’s policy stance.

Last week, ECB President Mario Draghi appeared to go out of his way to counter speculation that the central bank is about to ease policy some more.

But, as the negative news continues to mount, there will come a point when the ECB’s denials will no longer be believed and investors will start looking for lower interest rates.

That is the point at which reality will kick in and the euro, regardless of the level of debtor nations’ yields, will start to fall.